Forward exchange transactions (forwards) are the ideal instrument for hedging exchange rate risks. For example, by fixing the exchange rate for a future deal already today, an importer can secure his expected profit from importing goods. In contrast to an immediate currency exchange (spot transaction), the interest rate differential is taken into account when calculating this so-called forward rate.
How do you calculate the forward rate?
The interest rate differential between the two currencies is quoted in the form of forward points in a forward transaction. If the interest rate level in a foreign currency is higher than in the Swiss franc, a discount is applied. In the opposite scenario, with lower interest rates in the other currency, there is a premium. In the first case the forward rate is lower than the current spot exchange rate, in the second case the forward rate is higher than the spot rate.
Taking EUR/CHF as an example, the situation on 13.11.2019 is as follows:
|Maturity||Forward points||Exchange rate|
Due to the higher interest rates in Europe, it is possible to benefit from a discount when buying euros on a future date. Thereby, the spot exchange rate is reduced by the forward points. When selling EUR with a forward contract, on the other hand, the discount causes additional hedging costs.